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Practice Problem Set 3 With Answers

The document describes a scenario involving an investment with three possible outcomes (A, B, C) that have different probabilities and payoffs. Some information is missing from the scenario. It then provides multiple choice questions to infer the missing probability and payoff. Additional questions assess concepts related to risk preferences and expected utility. An example calculates the maximum insurance premium a farmer would pay given his utility function and the probability and impact of a flood.

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100 views

Practice Problem Set 3 With Answers

The document describes a scenario involving an investment with three possible outcomes (A, B, C) that have different probabilities and payoffs. Some information is missing from the scenario. It then provides multiple choice questions to infer the missing probability and payoff. Additional questions assess concepts related to risk preferences and expected utility. An example calculates the maximum insurance premium a farmer would pay given his utility function and the probability and impact of a flood.

Uploaded by

Joy colab
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Practice problem set 3

Managerial Economics
PGP, 2020-2021

Scenario 5.4:
Suppose an individual is considering an investment in which there are exactly three possible
outcomes, whose probabilities and pay-offs are given below:

Outcome Probability Pay-offs


A .3 $100
B ? 50
C .2 ?

The expected value of the investment is $25. Although all the information is correct,
information is missing.

1) Refer to Scenario 5.4. What is the probability of outcome B?


A) 0
B) -0.5
C) 0.5
D) 0.4
E) 0.2
Answer: C

2) Refer to Scenario 5.4. What is the pay-off of outcome C?


A) -150
B) 0
C) 25
D) 100
E) 150
Answer: A

3) Other things equal, expected income can be used as a direct measure of well-being
A) always.
B) no matter what a person's preference to risk.
C) if and only if individuals are not risk-loving.
D) if and only if individuals are risk averse.
E) if and only if individuals are risk neutral.
Answer: E

4) An individual with a constant marginal utility of income will be


A) risk averse.
B) risk neutral.
C) risk loving.
D) insufficient information for a decision
Answer: B

1
Short answer questions:

5) Describe Larry, Judy and Carol's risk preferences. Their utility as a function of income is
given as follows

Larry: UL(I) = 10 .
Judy: UJ (I) = 3I2.
Carol: UC (I) = 20I.

Answer: Larry's marginal utility of income is . As income increases, his marginal utility
of income diminishes. This implies that Larry is risk-averse. Judy's marginal utility of
income is 6I. As income increases, her marginal utility of income increases. This implies
that Judy is a risk-lover. Carol's marginal utility of income is 20. As income increases, her
marginal utility of income is constant. This implies that Carol is risk-neutral.

6) Sam's utility of wealth function is U(w) = 15 . Sam owns and operates a farm. He is
concerned that a flood may wipe out his crops. If there is no flood, Sam's wealth is $360,000.
The probability of a flood is 1/15. If a flood does occur, Sam's wealth will fall to $160,000.
Calculate the maximum premium Sam is willing to pay for flood insurance.
Answer:

Sam's expected utility is EV[U(w)] = [15 ]+ [15 ].


= 400 + 8,400 = 8,800.
The level of wealth Sam needs with certainty to ensure this same level of utility is found by
solving

U(wC) = 15 = 8,800 for wC. This will be wC = = $344,177.76. Sam's


premium is then the difference between his current wealth and wC. This implies Sam is
willing to pay $15,822.24 for insurance against a flood.

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